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The Right To Exercise An Option


As Rookies, one of the most basic concepts we learn is that: An option gives its owner the right, but not the obligation to exercise the option at any time before the option expires. Eventually we learn that this applies only to American style options and that European options may only be exercised only when expiration arrives.

Every so often I receive a question or comment from an option trader that makes me realize something: No matter how basic the explanation, there may be something else going on that causes confusion in the mind of that trader.

 

For example:

 

A trader sells an option, eventually covers the short position and asks whether it is still possible to be assigned an exercise notice.

 

We all know the answer is: ‘NO’

 

You cannot be assigned an exercise notice when you are no longer short the option. So how can this become a problem? In my opinion it stems from the fact that all our definitions are not quite 100% clear.

 

In this instance, the option owner still retains the right to exercise. However, our definition clearly states that someone who sold that option can be assigned an exercise notice. What is missing is a clear distinction that the obligation is transferred to the new seller when the original seller covers (purchases, in a closing transaction) that position.

 

Bottom line: Only the option owner may exercise; only someone with a current short position can be assigned.

 

Pretty simple concept, but occasional questions arise.

 

A more recent example:

 

I thought spreads were a single trade, and couldn’t be “picked apart.

 

The trader was disconcerted when assigned an exercise notice on the option sold as part of a spread. There are several basic points to be addressed.

  1. Yes. The spread is a single ORDER and cannot be picked apart. When you enter a spread order, you are filled on ALL PARTS of the order, or none. It cannot be picked apart.
  2. Once the order is filled, the trader owns a spread position. As far as you are concerned, this is a single (hedged) position and you intend to trade it as such. However, the rest of the options universe does not know anything about you or your plans. The OCC (Options Clearing Corporation) knows nothing about you either.
  3. Sometimes the conversion of an option into stock can result in a margin call. That is a real problem, especially when the broker gives the customer 10 minutes to meet that call. [some years ago, traders had a few days.]

What the OCC does know is that you own option A and that you have a short position in option B. Nothing else matters.

 

Why? When any person exercises an option, the OCC verifies that the person has the right to exercise (i.e., that person owns the option). Next the OCC assigns that exercise notice to a randomly-chosen broker. The broker finds all of its customer accounts with a short position in that option and via specific process (usually random selection) chooses an account to receive that notice.

 

No account is immune. No account owner can say that he/she was hedged and is therefore exempt form being assigned. Once that assignment notice has been received, the deal is final and cannot be undone. In our example, the customer sells 100 shares short and receives the strike price in cash.

 

Consider this possibility: A new option series is listed for trading. That day, the option never trades – except for one spread order. If the option seller were exempt form being assigned, then the option owner would not have the right to exercise, and that is not possible.

 

In the specific situation involving the person who send the question, he was trading in an IRA account. Under no circumstances may anyone be short stock in an IRA, so he was required to fix the situation immediately. He elected to sell his long option and buy the short stock. He could have re-established the original position (risking another assignment) by buying stock and selling the same call sold earlier.

 

Early assignment is not always a a problem. However this time a short stock position was in an IRA account and the trader was forced to exit the stock position. Being unable to meet a margin call is always s distinct risk when trading options. Using European-style index options eliminates that risk, but significantly reduces your vehicles for trading.

 

Bottom line: If you are short an American-style option, you may be assigned at any time.

 

Mark Wolfinger has been in the options business since 1977, when he began his career as a floor trader at the Chicago Board Options Exchange (CBOE). Since leaving the Exchange, Mark has been giving trading seminars as well as providing individual mentoring via telephone, email and his premium Options For Rookies blog. Mark has published four books about options. His Options For Rookies book is a classic primer and a must read for every options trader. Mark holds a BS from Brooklyn College and a PhD in chemistry from Northwestern University.

 

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